Here are my most relevant quotes from the book “The Most Important Thing”, plus my own comments
Introduction
The Most Important Thing Is…
1. Second-Level Thinking
2. Understanding Market Efficiency (and Its Limitations)
3. Value
4. The Relationship Between Price and Value
5. Understanding Risk
6. Recognizing Risk
7. Controlling Risk
8. Being Attentive to Cycles
9. Awareness of the Pendulum
10. Combating Negative Influences
11. Contrarianism
12. Finding Bargains
13. Patient Opportunism
14. Knowing What You Don’t Know
15. Having a Sense for Where We Stand
16. Appreciating the Role of Luck
17. Investing Defensively
18. Avoiding Pitfalls
19. Adding Value
20. Pulling It All Together
“What have been the keys to your success?” My answer is simple: an effective investment philosophy, developed and honed over more than four decades and implemented
conscientiously by highly skilled individuals who share culture and values. (Xii)
- I must have an effective investment philosophy
Second- level thinking is deep, complex and convoluted. The second level thinker takes a great many things into account:
• What is the range of likely future outcomes?
• Which outcome do I think will occur?
• What’s the probability I’m right?
• What does the consensus think?
• How does my expectation diff er from the consensus?
• How does the current price for the asset comport with the consensus view of the future, and with mine?
• Is the consensus psychology that’s incorporated in the price too bullish or bearish?
• What will happen to the asset’s price if the consensus turns out to be right, and what if I’m right?
The difference in workload between first- level and second- level thinking is clearly massive, and the number of people capable of the latter is tiny compared to the number capable of the former. (4)
- I must have second level thinking
Think of it this way:
• Why should a bargain exist despite the presence of thousands of investors who stand ready and willing to bid up the price of anything that’s too cheap?
• If the return appears so generous in proportion to the risk, might you be overlooking some hidden risk?
• Why would the seller of the asset be willing to part with it at a price from which it will give you an excessive return?
• Do you really know more about the asset than the seller does?
• If it’s such a great proposition, why hasn’t someone else snapped it up?
- what is second level thinking?
There’s more. If you’ve settled on the value approach to investing and come up with an intrinsic value for a security or asset, the next important thing is to hold it firmly. Th at’s because in the world of investing, being correct about something isn’t at all synonymous with being proved correct right away.
What is it that makes a security— or the underlying company— valuable? Th ere are lots of candidates: financial resources, management, factories, retail outlets, patents, human resources, brand names, growth potential and, most of all, the ability to generate earnings and cash flow. In fact, most analytical approaches would say that all those other characteristics— financial resources, management, factories, retail outlets, patents, human resources, brand names and growth potential—are valuable precisely because they can translate eventually into earnings and cash flow.
The emphasis in value investing is on tangible factors like hard assets and cash flows. Intangibles like talent, popular fashions and long- term growth potential are given less weight. Certain strains of value investing focus exclusively on hard assets.
the convergence of price and intrinsic value can take more time than you have; as John Maynard Keynes pointed out, “The market can remain irrational longer than you can remain solvent.” (30)
- stick with value approach and be patient to wait
“ Being too far ahead of your time is indistinguishable from being wrong.” So now that security worth 80 is priced at 50 instead of 60. What do you do? (22)
A “top” in a stock, group or market occurs when the last holdout who will become a buyer does so. Th e timing is oft en unrelated to fundamental developments. (28)
- Timing is crucial, in order to be right, think through everything, be patient to wait for the best opportunities, and buy LEAPS only with large 40~50% margin, buy stock with at least 30% margin, also sell it when already profit handsomely. When total market slumps, and stock price slumps, sell stocks and buy options in order to bounce higher.
The discipline that is most important is not accounting or economics, but psychology.
The key is who likes the investment now and who doesn’t. Future price changes will be determined by whether it comes to be liked by more people or fewer people in the future.
Investing is a popularity contest, and the most dangerous thing is to buy something at the peak of its popularity. At that point, all favorable facts and opinions are already factored into its price, and no new buyers are left to emerge. The safest and most potentially profitable thing is to buy something when no one likes it. Given time, its popularity, and thus its price, can only go one way: up. (27)
- Investment is about psychology – Mostly it comes down to psychology that’s too positive and thus prices that are too high; when my portfolio drops significantly, I dare not to look at it and therefore miss many opportunities to double down on my investment.
Why do I say risk assessment is such an essential element in the investment
process? There are three powerful reasons.
First, risk is a bad thing, and most level- headed people want to avoid or minimize it. It is an underlying assumption in financial theory that people are naturally risk- averse, meaning they’d rather take less risk than more. Thus, for starters, an investor considering a given investment has to make judgments about how risky it is and whether he or she can live with the absolute quantum of risk.
Second, when you’re considering an investment, your decision should be a function of the risk entailed as well as the potential return. This process of adjusting relative prices, which economists call equilibration, is supposed to render prospective returns proportional
to risk.
Third, when you consider investment results, the return means only so much by itself; the risk taken has to be assessed as well. (32)
- Why risk assessment is an essential element in investment?
The possibility of permanent loss is the risk I worry about, Oaktree worries about and every practical investor I know worries about. But there are many other kinds of risk, and you should be conscious of them, because they can either (a) affect you or (b) affect others and thus present you with opportunities for profit.
Investment risk comes in many forms. Many risks matter to some investors but not to others, and they may make a given investment seem safe for some investors but risky for others.
• Falling short of one’s goal— Investors have differing needs, and for each investor the failure to meet those needs poses a risk. A retired executive may need 4 percent per year to pay the bills, whereas 6 percent would represent a windfall. But for a pension fund that has to average 8 percent per year, a prolonged period returning 6 percent would entail serious risk. Obviously this risk is personal and subjective, as opposed to absolute and objective. A given investment may be risky in this regard for some people but riskless for others. Th us this cannot be the risk for which “the market” demands compensation in the form of higher prospective returns.
• Underperformance—Let’s say an investment manager knows there won’t be more money forthcoming no matter how well a client’s account performs, but it’s clear the account will be lost if it fails to keep up with some index. Th at’s “benchmark risk,” and the manager can eliminate it by emulating the index. But every investor who’s unwilling to throw in the towel on outperformance, and who chooses to deviate from the index in its pursuit, will have periods of significant underperformance. In fact, since many of the best investors stick most strongly to their approach— and since no approach will work all the time—
the best investors can have some of the greatest periods of underperformance. Specifically, in crazy times, disciplined investors willingly accept the risk of not taking enough risk to
keep up. (See Warren Buffett and Julian Robertson in 1999. That year, underperformance was a badge of courage because it denoted a refusal to participate in the tech bubble.)
• Career risk— This is the extreme form of underperformance risk: the risk that arises when the people who manage money and the people whose money it is are different people. In those cases, the managers (or “agents”) may not care much about gains,
in which they won’t share, but may be deathly afraid of losses that could cost them their jobs. Th e implication is clear: risk that could jeopardize return to an agent’s firing point is rarely worth taking.
• Unconventionality—Along similar lines, there’s the risk of being different. Stewards of other people’s money can be more comfortable turning in average performance, regardless of where it stands in absolute terms, than with the possibility that unconventional
actions will prove unsuccessful and get them fired. . . . Concern over this risk keeps many people from superior results, but it also creates opportunities in unorthodox investments for those who dare to be different.
• Illiquidity—If an investor needs money with which to pay for surgery in three months or buy a home in a year, he or she may be unable to make an investment that can’t be counted on for liquidity that meets the schedule. Th us, for this investor, risk isn’t
just losing money or volatility, or any of the above. It’s being unable when needed to turn an investment into cash at a reasonable price. This, too, is a personal risk. (37)
- Many forms of risk
First, risk of loss does not necessarily stem from weak fundamentals. A fundamentally weak asset— a less- than- stellar company’s stock, a speculative- grade bond or a building in the wrong part of town— can make for a very successful investment if bought at a low- enough price.
Second, risk can be present even without weakness in the macro environment. The combination of arrogance, failure to understand and allow for risk, and a small adverse development can be enough to wreak havoc. It can happen to anyone who doesn’t spend the time and effort required to understand the processes underlying his or her portfolio.
Mostly it comes down to psychology that’s too positive and thus prices that are too high. Investors tend to associate exciting stories and pizzazz with high potential returns. They also expect high returns from things that have been doing well lately. These souped- up investments may deliver on people’s expectations for a while, but they certainly entail high risk. (38)
- Where does risk come from – mostly from psychology
how do they measure that risk?
First, it clearly is nothing but a matter of opinion: hopefully an educated, skillful estimate of the future, but still just an estimate.
Second, the standard for quantification is non existent. With any given investment, some people will think the risk is high and others will think it’s low. Some will state it as the probability of not making money, and some as the probability of losing a given fraction of their money (and so forth). Some will think of it as the risk of losing money over one year, and some as the risk of losing money over the entire holding period. Clearly, even if all the investors involved met in a room and showed their cards, they’d never agree on a single number representing an investment’s riskiness. And even if they could, that number wouldn’t likely be capable of being compared against another number, set by another group of investors, for another investment. This is one of the reasons why I say risk and the risk/return decision aren’t “machinable,” or capable of being turned over to a computer.
Ben Graham and David Dodd put it this way more than sixty years ago in the second edition of Security Analysis, the bible of value investors: “the relation between different kinds of investments and the risk of loss is entirely too indefinite, and too variable with changing conditions, to permit of sound mathematical formulation.”
Third, risk is deceptive. Conventional considerations are easy to factor in, like the likelihood that normally recurring events will recur. But freakish, once- in- a-lifetime events are hard to quantify. Th e fact that an investment is susceptible to a particularly serious risk that will occur infrequently if at all— what I call the improbable disaster— means it can seem safer than it really is.
The bottom line is that, looked at prospectively, much of risk is subjective, hidden and unquantifiable.
Where does that leave us? If the risk of loss can’t be mea sured, quantified or even observed— and if it’s consigned to subjectivity— how can it be dealt with? Skillful investors can get a sense for the risk present in a given situation. They make that judgment primarily based on (a) the stability and dependability of value and (b) the relationship between price and value.
Other things will enter into their thinking, but most will be subsumed under these two.
There have been many efforts of late to make risk assessment more scientific. Financial institutions routinely employ quantitative “risk managers” separate from their asset management teams and have adopted computer models such as “value at risk” to measure the risk in a portfolio. But the results produced by these people and their tools will be no better than the inputs they rely on and the judgments they make about how to process
the inputs. In my opinion, they’ll never be as good as the best investors’ subjective judgments. Given the difficulty of quantifying the probability of loss, investors who want some objective measure of risk- adjusted return— and they are many— can only look to the so- called Sharpe ratio. This is the ratio of a portfolio’s excess return (its return above the “riskless rate,” or the rate on short- term Treasury bills) to the standard deviation of the return. Th is calculation seems serviceable for public market securities that trade and
price oft en; there is some logic, and it truly is the best we have. While it says nothing explicitly about the likelihood of loss, there may be reason to believe that the prices of fundamentally riskier securities fluctuate more than those of safer ones, and thus that the Sharpe ratio has some relevance. For private assets lacking market prices— like real estate and whole companies— there’s no alternative to subjective risk adjustment.
Bruce has put it admirably into words: “Th ere’s a big difference between probability and outcome. Probable things fail to happen— and improbable things happen— all the time.”
That’s one of the most important things you can know about investment risk. (42)
- How can I measure the risk?
For the most part, I think it’s fair to say that investment performance is what happens when a set of developments— geopolitical, macro- economic, company- level, technical and psychological— collide with an extant portfolio. Many futures are possible, to paraphrase Dimson, but only one future occurs.
